What documentation is needed to prove QBI eligibility during an IRS audit?
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To substantiate eligibility for the Qualified Business Income (QBI) deduction during an IRS audit, a taxpayer must maintain comprehensive documentation that supports both the calculation of the deduction and the underlying eligibility requirements. The IRS and Treasury Regulations, as well as practical guidance, specify the following key documentation requirements:
1. Proof of Qualified Business Income (QBI) and Business Activity
- Business Records: Maintain detailed books and records that demonstrate the existence of a domestic trade or business. This includes:
- Invoices, receipts, and contracts showing business operations.
- Bank statements and ledgers reflecting business income and expenses.
- Documentation of regular and continuous involvement in the business, especially for rental real estate (e.g., property management agreements, logs of activity) to establish that the activity rises to the level of a trade or business under section 162 and, if applicable, meets the safe harbor in Rev. Proc. 2019-38.
- Pass-Through Entity Documentation: For partnerships and S corporations, retain Schedule K-1s and any supporting statements that report each owner’s share of QBI, W-2 wages, and unadjusted basis of qualified property.
2. Payroll and Wage Documentation (for Wage/Property Limitation)
- Payroll Records: Keep year-end payroll summaries, Forms W-2, W-3, and quarterly payroll tax filings to substantiate W-2 wages paid by the business. These are critical if taxable income exceeds the QBI threshold and the wage/capital limitation applies.
- Allocation Records: If the business has multiple trades or businesses, maintain records showing how W-2 wages are allocated among them, using a reasonable and consistent method.
3. Qualified Property Documentation
- Depreciation Schedules and Asset Registers: Retain fixed asset registers, depreciation schedules, and purchase agreements to establish the unadjusted basis immediately after acquisition (UBIA) of qualified property. This is necessary for applying the 2.5% property limitation if the wage/capital limitation is relevant.
4. Aggregation Documentation (if applicable)
- Ownership and Operational Records: If multiple businesses are aggregated for QBI purposes, keep documentation demonstrating common ownership (50% or more), same tax year, and satisfaction of at least two of the required factors (e.g., shared products/services, facilities, or centralized business elements). Attach aggregation statements to the tax return as required.
5. Exclusion and Allocation Documentation
- Compensation and Guaranteed Payments: Maintain records showing amounts paid as reasonable compensation to S corporation shareholders or guaranteed payments to partners, as these are excluded from QBI.
- Tracking Suspended Losses: Use worksheets (such as the QBI Loss Tracking Worksheet in IRS instructions) to track losses or deductions suspended by other provisions (e.g., sections 461(l), 465, 469, 704(d), 1366(d)), and their subsequent inclusion in QBI when allowed.
6. Specified Service Trade or Business (SSTB) Documentation
- Business Activity Descriptions: For businesses potentially classified as SSTBs, maintain clear records and descriptions of business activities, revenue streams, and, if bifurcating, evidence supporting the allocation between SSTB and non-SSTB activities.
7. Tax Return Workpapers and Supporting Schedules
- QBI Calculation Workpapers: Retain all workpapers used to calculate the QBI deduction, including those supporting the 20% limitation, taxable income calculations, and any phase-in or phase-out computations.
- Tax Forms: Keep copies of filed Forms 8995 or 8995-A, including all attached schedules (e.g., Schedule A for SSTBs, Schedule B for aggregation, Schedule C for loss netting, and Schedule D for cooperatives).
8. Additional Documentation for Trusts and Estates
- Distributable Net Income (DNI) Allocations: For trusts and estates, maintain records showing the allocation of section 199A items based on DNI, and any information provided to beneficiaries.
9. Summary Table of Essential Documentation:
10. Retention and Presentation
- All documentation should be retained for as long as it may be material to the administration of any Internal Revenue law, generally at least three years after the filing date of the return, but longer if losses or deductions are carried forward or if the IRS requests additional substantiation.
11. Conclusion
To prove QBI eligibility during an IRS audit, a taxpayer must be able to produce detailed records substantiating the existence and nature of the trade or business, the calculation of QBI, the application of wage and property limitations, the exclusion of non-qualifying income, and the proper allocation of income and losses. Proper documentation is essential to support the deduction and withstand IRS scrutiny.
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